COUNTY PENSION FUND SET TO LEND

Loans up to $200M would be available to middle-market firms

The county pension fund is moving forward with a proposal to use its $9 billion portfolio to make loans as high as $200 million available for middle-market companies that lack access to traditional capital.

The San Diego County Employees Retirement Association board discussed the proposal on Thursday and gave the green light for its outside portfolio strategist to prepare recommendations for managers to handle such a loan program.

The strategist, Lee Partridge of Houston, told trustees that with expected net returns that could surpass 10 percent, the opportunity is too good to pass up.

“There’s a supply-and-demand imbalance between capital and the need for capital,” he said. “We think this is a pretty attractive risk-reward trade-off.”

Following a direct-lending overview presented by the board’s general consultant, Partridge told trustees he would move forward.

“We will be presenting managers if the board likes this space and the story behind it,” he said.

According to consultant Satya Kumar of Hewitt Ennis Knupp, the plan is to hire managers to evaluate loan applications from companies in need of $20 million to $200 million for five to seven years.

The loans would be approved and serviced by the outside managers, who would target firms that agree to floating interest rates from 5.75 to 8.5 percent. Fees, prepayment penalties and loan modifications also would boost the net returns, Kumar said.

“When you add all these up, you are looking at high single-digits to low double-digits to the investor,” he said.

Trustees were told there is a growing market in such direct lending because banks have increasingly limited loans to those borrowers with higher credit ratings. In recent years, 85 percent of middle-market lenders have exited the market, Kumar said.

Retirement board members raised some questions about why the loans would be a good investment for a pension fund if banks have demurred.

“What do they know that we don’t?” asked Trustee Dan McAllister, who serves on the pension board because he is the elected county treasurer. “Why would this make a good play for us?”

Kumar said it’s not so much the market as it is the regulation thereof that has caused banks to shy away.

“A lot of this has to do with structural issues and regulatory issues that have moved a lot of the players out of the marketplace,” Kumar said.

Duke K. Bristow, a finance professor at the Marshall School of Business at the University of Southern California, said pension funds may be at a disadvantage to traditional lenders when it comes to making loans.

Banks are expert at writing terms that allow them to closely monitor borrowers and exercise provisions for calling in a note if, for example, revenues decline, he said.

“The question is, are the people who are stepping into those loans in the same position (as banks) to judge the quality and monitor the loan,” Bristow said. “It’s not clear to me that they are.”

Pension managers are constantly and rightfully on the hunt for the next success story in institutional investing, Bristow said.

In the 1980s, after the U.S. Department of Labor ruled that pensions could devote a small portion of assets to such investments, many funds turned to venture capital as a way to generate profits. It was controversial and initially hugely lucrative.

“That was a huge boon for San Diego, for California, for the U.S. and for the world,” Bristow said. “Now decades later, those same venture capital funds are struggling to repeat these earlier successes — so pension managers are looking to direct lending. Buyer beware.”

Joe Nation, a former state lawmaker who directs a public policy program for graduate students at Stanford University, said pension funds that buy into direct-lending pools are “effectively gambling.”

“Clearly those are riskier. There’s no doubt about that,” he said. “If you’re swinging for the fences, you might also strike out, and if you do you’re really stuck. You have obligations you still have to meet.”

Nation said too many public pension officials take unnecessary risks because they know taxpayers will bail them out if investments go sour.

“If you have a pension system and the board knows their ultimate backstop is the taxpayer, they’re going to take risks that they might not usually take,” he said.

In his report to trustees, Kumar noted there are key risks to direct lending.

Chief among those are the small number of managers capable of overseeing the loans; a lack of standard terms; variances in collateral available for borrowers; and illiquidity, the idea that the investments are locked up for years.

San Diego County’s is not the only public pension system exploring direct lending.

In January, the Orange County Employees Retirement System investment committee voted to retain a firm to find managers for $104 million that the fund plans to invest in middle-market loans.

U-T Watchdog contacted the National Federation of Independent Business in California and the California Chamber of Commerce to see if the business community welcomes the added capital option. Both declined to comment.